OVERVIEW

How is IHT charged?

Inheritance tax (IHT) is usually payable at either 20% on certain bequests, gifts and other transfers of property by individuals during lifetime or at 40% on death. Collectively, these are called “transfers of value”. It can also be charged on property held in a trust or owned by a close company – though this only applies where the transfers of value made by the company are deemed to be made by the participators as an anti-avoidance measure. The charge to tax is determined by the nature of the transfer, the relationship between the parties, and the circumstances of the individual, trust or company making the transfer.

Individuals who are domiciled in the UK are subject to IHT on any chargeable transfers, regardless of whether or not the property transferred is located in the UK. Non-UK domiciled individuals are only subject to IHT on property located in the UK (with some exceptions). 

Individuals may make transfers during their lifetime and are deemed to make a transfer of all their estate on death.

Lifetime transfers are divided into those which are immediately chargeable to IHT and those which are potentially exempt. A potentially exempt transfer (PET) will only give rise to an IHT charge if the donor dies within seven years of making the transfer. If they don’t survive seven years, the gift will be included in the estate as a “failed PET”, though taper relief may help to reduce the tax charge.

 

Transfers on death arise in relation to the property in the estate of the deceased.

For IHT purposes, the charge is made using the “loss to donor” principle, i.e. the amount that the donor’s estate is reduced by. This won’t always be the same as the value the recipient receives, e.g. if a small number of shares are transferred from a minority holding, but these give the recipient a controlling holding, they will be more valuable to the recipient.

Certain lifetime transfers are immediately chargeable to IHT at the lifetime rate (if they exceed the available nil rate band) of 20%. They can then be taxed again as part of the death estate depending on whether or not seven years has elapsed between the transfer and death, with a credit for any tax paid on the original transfer. Although transfers between individuals are not chargeable a transfer by an individual to some types of trust are.

 

Isn’t there a tax-free amount?

Yes, there is a nil rate band (NRB). This isn’t an exemption, rather a 0% rate. There is also a relatively new residence nil rate band (RNRB) that can enhance the tax-free amount which can pass on death. Determining the available NRB and RNRB is a crucial step in IHT planning, as IHT is a cumulative tax. This means that you must take account of any previous gifts that may have used up some or all of the NRB, so good record keeping is essential.

 

How do transfers between married couples work?

Assets can pass between spouses or civil partners free from IHT. This is known as the intra-spouse exemption. Generally, one spouse will leave everything to the surviving spouse, and it will be up to them to consider any IHT exposure that may arise on their own death. There are occasions where this planning isn’t suitable, particularly where there are children from prior marriages. There are also instances where tax savings can be made for the family as a whole by not leaving everything to the surviving spouse.

 

Haven’t I left it too late?

Healthy people in their 70s and 80s are often sceptical about their life expectancy, yet many do go on to live for more than seven years after considering IHT planning. Conversely, much younger people could have their lives cut short. Therefore, it’s recommended that wills and IHT mitigation plans are revisited regularly to check that they are still fit for purpose.

 

Are there non-tax reasons for making gifts in my lifetime?

People often describe the joy that making gifts brings to them, for instance if it helps a loved one who is struggling, starting a business or buying their first home. It’s necessary to ensure that lifetime gifts are not excessive so that your financial independence is maintained. A financial advisor can undertake cash-flow planning to give peace of mind that living expenses and life’s unexpected emergencies can still be paid for.

Others are more concerned about protecting the family wealth from irresponsible behaviour, addiction, bankruptcy or divorce, particularly when they are no longer around to advise and support the family. There are several ways to achieve asset protection, with tax usually being a secondary priority. Due to this, IHT planning that suits one family won’t be appropriate for a different one with identical finances. Of course, if you can achieve your primary objectives in a way that is tax-efficient, you get the best of both worlds.

 

DETERMINING THE NIL RATE BANDS

How much of the estate is covered by nil rate bands (NRBs)?

It’s important to assess how much the estate is worth, and how much can be passed down free from IHT before making any decisions. There are two NRBs for IHT purposes - the standard NRB and a residence NRB -  which, where available, set the amount (before reliefs or exemptions) that is not subject to IHT. The bands are determined independently of each other, and we will look at each of these in turn.

 

Who’s entitled to the NRB?

Every individual is entitled to the NRB, which has been £325,000 since 2009, and is frozen at this level until at least 2028, meaning more and more people are being dragged into the IHT net. The NRB ensures that individuals with estates worth £325,000 or less, or married couples with estates worth £650,000 or less, are not subjected to IHT. The NRB may be wholly or partially used where chargeable gifts were made in the seven years prior to death.

Lifetime gifts that are immediately chargeable to IHT also use the nil rate band, so when considering a lifetime gift, you need to look back at previous gifts. 

 

Can unused NRB be transferred?

Yes, any unused NRB/RNRB can be transferred to a spouse/civil partner on the second death. The transfer of the unused NRB needs to be claimed on the second death, it does not transfer automatically. You can use Form IHT402 (see here) to claim a transferable NRB. This will usually be done by the solicitor dealing with the estate, but if you are administering an estate yourself as an executor, you will need to do it directly.

The amount that can be transferred is expressed as a percentage such that, if none of the NRB was used on the first death, 100% of the NRB in effect at the time of the second death can be transferred. In the following example, not all of the NRB could be transferred.

Example

Iris died in May 2006, leaving £10,000 to her sister and the rest of her estate to her husband, Raymond. The assets that Iris left to Raymond pass free from IHT by virtue of their marriage. In May 2006 the NRB was £285,000, of which Iris’ estate used £10,000. Should Raymond die whilst the NRB is £325,000, his estate will have his own NRB of £325,000, plus a percentage of Iris’ unused NRB. £275,000 is 96% of £285,000, so Raymond’s estate can claim 96% of the NRB that Iris’ estate did not use. 96% of £325,000 = £312,000

NRB available on Raymond’s death £325,000 + £312,000 = £637,000.

 

 What if there’s been more than one marriage?

Additional NRBs can be claimed if an individual has survived more than one spouse. However, the maximum amount that an individual can use in respect of their own death estate is two times the NRB in force at their death. Where this applies it’s important to assess the NRBs on the first death, to ensure the allowances are not wasted.

Example - NRB wasted

John dies in 2010, leaving his entire estate to his wife, Lynda. In 2016 Lynda marries Derek. Derek dies in 2021, leaving everything to Lynda. As there are three people involved, three NRBs are available. However, on Lynda’s death, only the maximum of two NRBs can be claimed, meaning that one is wasted.

Example - using three NRBs

John dies in 2010, leaving his entire estate to his wife Lynda. In 2016 Lynda marries Derek.

Derek dies in 2021 and leaves £325,000 (the NRB amount) to his daughter. The balance of his estate passes to Lynda. There is no IHT payable on Derek’s death and his NRB isn’t wasted.

When Lynda dies, her estate can claim John’s and Lynda’s NRB. Thus allowing three NRBs to be used in total.

It would also be possible to utilise more NRBs, e.g. if Derek was a widower and his deceased spouse had transferred all of her estate to him upon her death. The planning above would be modified by making the gift to the daughter £650,000 rather than £325,000, meaning four NRBs will have been utilised. This would require proactive forward planning and will drafting.

Tax is only one factor of course, and it may not be practical or desirable to organise asset distribution in this way. It’s well worth checking though because each NRB is worth £130,000 (£325,000 x 40%) in saved IHT.

 

What’s the residence nil rate band (RNRB)?

The RNRB was introduced to allow the family home to pass down free from IHT. Where available, it allows up to an additional £175,000 to pass on death, free from IHT. This means that for a couple, the total nil rate bands total £1m.

 

Who’s entitled to the RNRB?

Individuals who leave their home to direct descendants can access the RNRB. The full amount is not available if the estate is valued at more than £2 million. If the value of the home is less than the RNRB, the RNRB is restricted to the value of the home.

 

Example

Ruth, who never married, dies and leaves her home, worth £150,000 and a share portfolio worth £400,000 to her son.  Ruth is entitled to the NRB and the RNRB. However, as her home is worth less than the RNRB, it is restricted to £150,000.

The IHT liability is calculated as follows:

Share portfolio	£400,000
Home	£150,000
RNRB	(£150,000)
NRB	(£325,000)
Total chargeable	£75,000
40% IHT	£30,000

 

 

 

 

 

 

 

 

What’s a direct descendant?

A direct descendant is a person’s child, grandchild, great grandchild, etc. It does not include the person’s parents, siblings or other non-lineal descendants. A direct descendant does not need to be a natural descendant and so could be adopted, a stepchild or foster child. It’s not necessary to leave the property to all of the direct descendants, as long as a direct descendant inherits it.

 

Can unused RNRB be transferred?

Yes, any unused RNRB can be transferred to a spouse/civil partner on the second death. This is the case even if the first death was before the RNRB was introduced. The transfer of the unused RNRB needs to be claimed on the second death, it does not transfer automatically.

The amount to be transferred is expressed as a percentage such that if none of the RNRB was used on the first death, 100% of the RNRB in force at the time of the second death, rather than the first, can be transferred. Where the RNRB was partly used on the first death, the unused percentage is applied to the RNRB in force at the time of the second death. This means that there may be an uplift in the amount transferred if the RNRB has increased since the first death.

Example

Nancy died in May 2017. At the time, the RNRB was £100,000. Nancy’s assets, and the way her will was made, meant that her estate used £60,000 of this. Her spouse Frank dies in 2024 when the RNRB is £175,000. The amount of RNRB to transfer is £175,000 x 60% = £105,000, i.e. more than the £40,000 that was unused on Nancy’s death.

 

What about spouses that died pre-6 April 2017?

As the RNRB was not introduced until 6 April 2017, the spouses of those who died before 6 April 2017 should have 100% of the RNRB brought forward. It does not matter if the deceased’s estate did not include a residence, but the RNRB could be reduced if the deceased’s estate was worth more than £2 million.

Example

Dylan’s home is worth £500,000 and his total net worth is £2.2m.

The RNRB is calculated as follows:

£2.2m – £2m = £200,000

£200,000/2 = £100,000

The RNRB will be reduced by £100,000.

£175,000 - £100,000 = £75,000 RNRB available

 

What if a property has been sold?

It’s not unusual for older people to sell and purchase a smaller property or to move into a care home and sell the property to help pay the fees. There is a specific “downsizing” provision that applies in these situations to preserve entitlement to the RNRB. The amount of RNRB that would have been lost is reinstated as a “downsizing addition”, providing there are other assets representing the value of the original home in the estate, and these are then inherited by a direct descendant (also referred to as being “closely inherited”).

If you choose to downsize, it would be a good idea to lodge the proceeds into a separate bank account so that the value of the original home can easily be identified and can be a specific legacy to a direct descendant.

 

How can I maximise the RNRB?

 

Estate is valued at less than £2 million

[Ensure the property will be inherited by a direct descendant (child, stepchild, adopted/foster child, grandchild, etc). Monitor the value of the estate to ensure it does not exceed £2 million. If it does, or it is starting to get close to it, consider making gifts that qualify for immediate exemption from IHT.

Also, check whether there is any unused RNRB from a deceased spouse to carry forward and ensure the executors know it is there to claim.

 

Estate is valued at more than £2 million

The RNRB can save a family up to £140,000 in IHT so it is worth checking whether it is feasible to reduce the estate to below £2 million.

This can be achieved by making lifetime gifts. The value of the estate for the purposes of the RNRB taper is calculated at the date of death and doesn’t include gifts made prior to death.

This means that a person, knowing they do not have long left to live, could give away assets to ensure their estate will benefit from the full RNRB.

Note that assets which qualify for certain reliefs, e.g. business property relief, are included when calculating the value of the estate for this purpose.

Example

Doris, who never married, owns a home worth £500,000, a rental property worth £250,000 and has £2m cash savings. She has two adult children.

As her estate is worth £2.75m, if she does nothing, her estate won’t benefit from the RNRB on her death and IHT liability would be:

Estate value	£2.75m
NRB	(£325,000)
Taxable estate	£2.425m
40% IHT	(£970,000)
Available to inherit	£1.78m

 

 

 

 

 

 

In this case, the IHT bill is almost £1m, leaving Doris’ children with £1.78m.

If Doris undertakes some IHT planning, she can improve the position.

Example

If Doris reduces her estate to £2m or less before she dies, her estate will benefit from the full RNRB.

For instance, if Doris becomes terminally ill, she could gift £750,000 to her children. The estate value for the purposes of calculating the RNRB is £2m, so Doris’ estate is entitled to the full £175,000. This will also mean two annual exemptions are used. The IHT liability would be calculated like this:

Estate value	£2m
Failed PET	£750,000
2 x annual exemption	(£6,000)
Chargeable failed PET	£744,000
NRB	(£325,000)
Balance of failed PET	£419,000
RNRB	(£175,000)
Taxable estate	£2.244m
40% IHT	(£897,600)
Available to inherit	£1,102,400
Lifetime gift already received	£750,000
Total received by beneficiaries	£1,852,400

 

 

 

 

 

 

 

 

 

 

 

 

 

As shown above, over £70,000 is saved and goes straight to Doris’ children.

Note that it was not possible to escape IHT on the gift made. This is because Doris did not survive seven years from the date of the gift, which is therefore a failed PET.

Ideally, IHT would have been considered well in advance of death, but if it hasn’t, this example shows that IHT savings can still be made in these circumstances.

 

MAKING EFFICIENT INVESTMENTS

How can certain investments help?

Where there are concerns that a person may not survive for at least seven years, choosing to invest in assets that qualify for relief could be considered. Whilst making a gift would start the seven-year clock, investing in assets that qualify for business property relief (BPR) could be exempt from IHT after just two years.

BPR reduces the value of property by 50% or 100% for the purposes of the IHT calculation.

A less common relief is agricultural property relief (APR) which can apply to agricultural land and buildings. However, it is unlikely to be applicable in the context of mainstream investments for most people, so we will not consider it here.

 

What conditions must be met to qualify for BPR?

To qualify for the relief, the business property must have been owned for at least two years, be relevant business property and the business activity must not be wholly or mainly that of dealing in securities, stocks or shares, land or buildings or making or holding investments.

 

What is relevant business property?

The following assets are relevant business property that could attract relief at 100%:

• a business
• an interest in a business, such as a partner’s share in a partnership
• unquoted shares in a company - shares that are not listed on a recognised stock exchange, including AIM shares
• controlling holdings of unquoted securities (such as loan notes) in a company.

Whereas these assets constitute relevant business property that could attract relief at 50%:

• controlling holdings of quoted shares or securities
• land, buildings, plant or machinery used in a company controlled by you or a partnership that you are a member of.

Professional advice should be sought if you believe BPR applies to your business or shares. There are several conditions that must be met, and exclusions that could apply. In addition, certain assets within the business can be excluded for the purposes of the relief.  For example, if a business invests excess profits into non-trading activities, e.g. residential property, this could jeopardise the relief.

 

Who can invest?

BPR is most relevant for business owners but anyone who wants to invest in unquoted trading businesses can access the relief. It will be of particular interest to those in the later stages of life because the investment qualifies for relief in as little as two years.

It should be noted that BPR qualifying investments tend to be regarded as high risk. For this reason, investment managers usually have prescribed limits on the amount they can invest in BPR assets for their clients. For example, it could be limited to 10% of the client’s total investment with that company.  

 

Are there any other tax benefits to these investments?

If the investment also qualifies for enterprise investment scheme (EIS) or seed EIS relief, you could be eligible for attractive income tax and capital gains tax reliefs, further enhancing your wealth. The government has added tax advantages to investing in such companies to encourage the investment into high-risk startup companies.

Schemes involving taking out loans to purchase BPR qualifying assets will not work. The value of the loan will reduce the value of the asset it was used to purchase in the IHT estate.

Example

Ginny takes out a loan of £100,000 and purchases a BPR qualifying investment. She dies three years later. The value of the investment when she dies is £110,000, and the loan outstanding is £98,000. The value of the loan specifically reduces the value of the investment in her estate. The difference is £12,000, which is exempt from IHT.

 

What about my private pensions?

Registered pension schemes, i.e. those that meet conditions set by the government, are highly tax-efficient wrappers, both during your lifetime and, potentially, on your death. Pension savings are usually structured so that they are outside of your estate. This can make them a valuable, ready-made IHT planning tool. There are different rules for different types of pension, so it’s worth checking the IHT treatment, who can benefit from your pension when you die and how that person would be taxed on withdrawals before making any plans. It’s a complex area, so it would be worth speaking to your pension provider if you have any queries and want to utilise this planning.

Once you have confirmed these points with your pension provider, you should also ensure that the expression of wishes is up to date. This is a form that you submit to your pension provider, detailing who should benefit from your pension in the event of your death. In some cases it may be worth making additional contributions with excess savings, particularly as the lifetime allowance charge has been removed for 2023/24 and is set to be abolished for 2024/25.

 

Case study

Jude and Richard are a married couple in their 60s and have the following assets:

Main home	£750,000
Holiday apartment	£150,000
Cash savings	£200,000
Investment portfolio	£300,000
Pension funds	£400,000
Total	£1.8m

 

 

 

 

 

 

 

They are both retired and receive a state pension. Both properties are mortgage free, and they estimate their joint income needs to be £35,000 per annum.

Assuming the pension funds are outside of their IHT estates, the value of the joint estate is £1.4m. They live off their pensions and leave everything else untouched, determined to leave the maximum amount possible to their two children. On the second death, ignoring any growth in value of the assets in the estate, after  deducting their NRBs and RNRBs, IHT will be due on £400,000. The IHT bill will be £160,000.

 

Implemented planning

A more tax-efficient way to approach their retirement would be to first exhaust their cash savings, and then draw down the investment portfolio before resorting to their pensions.

The exception to this rule is where you’re in poor health and in the two years before you die you make significant contributions with the result that your (IHT-free) estate is reduced while your pension fund, which will go to your beneficiaries direct, is increased.

Assuming the state pension pays around £15,000 between them, they would need around £20,000 per annum from their savings.

After ten years, the cash savings would be extinguished and the IHT bill would have halved. Yet their children would receive the untouched pension funds.

This example does of course ignore any growth in the value of assets over those ten years, and Jude and Richard may not feel comfortable living on their cash reserves. However, particularly with larger estates, it’s worth preparing comparative calculations and mapping out income requirements to check whether drawing a pension, and paying income taxes on that pension, is really necessary. If it isn’t, then IHT savings could be achieved.

This underlines exactly why the tax tail shouldn’t wag the family dog, i.e. don’t overlook the big picture when it comes to succession planning.

 

Is tax payable on an inherited private pension?

While there is no IHT on inherited registered pension funds, if you die on or after your 75^th birthday, any lump sum or pension paid to the persons you nominated to receive it counts as income, which is liable to income tax, for them. If you die before reaching 75, any payments made to your nominated beneficiaries are usually entirely tax free.

 

What about defined benefit pensions?

A pension from a defined benefit plan can usually only be paid to a dependant of the person who died, e.g. a husband, wife, civil partner or child under 23. It can sometimes be paid to someone else if the pension scheme’s rules allow it - but it will be taxed at up to 55% as an unauthorised payment.

 

Are there products that can save IHT quickly?

You may have heard of discounted gift trusts (DGTs). Unlike outright gifts to your beneficiaries, DGTs give immediate IHT savings to people who, while wanting income from their assets, don’t need the capital which produces it. Naturally, there’s a cost involved; the insurance company will charge set-up fees and annual management charges to look after the scheme. However, the potential IHT savings will exceed these, which is why they are successful.

DGTs require you to invest a lump sum which will be invested into an insurance bond. In return you’ll be paid an annuity. Typically, this will be equal to 5% per annum of the amount you invested and as long as what you receive doesn’t exceed this, it’s tax free for up to 20 years. You can take a lesser or greater amount, but if greater you might have to undergo a health assessment and the excess will count as taxable income.

The bond you purchase is placed into a trust for the beneficiaries of your estate. The insurance company works out the current value of the annuity it anticipates it will have to pay you. Because this is always less than the value of the bond, the difference is “discounted” from your estate with immediate effect.

The discount is the market value of the retained payments. This means that the discount will decrease as your life expectancy shortens, so it’s better to invest sooner rather than later. HMRC does not accept that DGTs work if you have a short life expectancy, e.g. if you have a terminal illness or are 90 or older.

Example

You purchase a bond for £300,000 which is held in trust for your beneficiaries. You have chosen to receive payments from the trust equal to 4% (£12,000) of the bond’s value per year. Taking account of your age and health, the insurance company estimates that the current value of the return is £180,000.

If you had made an outright gift of £300,000 to your beneficiaries, it would have remained liable to IHT until seven years had elapsed. However, because you’ve only given away £120,000 (£300,000 - £180,000), it’s this which will count as part of your estate for IHT purposes if you don’t survive seven years from the date the bond was put in trust. There’s an immediate IHT saving of up to £72,000 (£180,000 x 40%).

If you survive seven years, the total cost of the bond (£300,000) will escape IHT. After your death whatever value is left in the bond is paid (tax free) to your beneficiaries.

 

What about life insurance?

 

Life insurance policies generally pay out a lump sum on the event of your death, according to their terms and conditions. They can be extremely IHT efficient as they can be written in trust, meaning that the payout is directly to named beneficiaries rather than to your estate. The lump sum is not subject to IHT and can be paid out before the grant of probate.

Policies are usually paid for by paying monthly premiums which are calculated based on your age, lifestyle, health, etc. Payment of the premiums is not a gift, so the money spent reduces your taxable assets.

The problem with taking out a policy later in life is that it will be more expensive than doing it when you are younger. If you have chronic health conditions, you may find it difficult to find a provider at all.

If you are in reasonably good health, you could consider taking out a whole of life policy (sometimes called life assurance) in exchange for a one-off payment. The premium paid reduces your cash assets for IHT purposes and, as long as you write the policy into trust, the payout will also be outside your estate. You’ve effectively turned a chunk of your taxable assets into an IHT-exempt payout.

You will need to speak to a reputable financial advisor to ensure the policy you choose meets your needs. Having the policy written into trust is a specialised area, so ensure this is offered. Premiums vary between providers, so ensure you speak to several.

You could also consider using a fixed-term insurance policy to protect against an IHT charge on a failed PET, i.e. you would make a gift and take out an insurance policy that would pay out an amount equal to the likely IHT charge if you die within seven years.